Is there a Rainbow somewhere?

All:

This has been a very tough few weeks. As bad as the market was at the beginning of the year through the middle of March, this is much worse. Now the economy has joined housing in the dumpster. And with a vaccuum in government between the Presidents, the timing could not be worse (I wonder if it is any coincidence that previous major market bottoms in 1932 and 1974 were during Presidential transitions, as well).

I still plan to review some of my small cap favorites and their Q3 reports. There is a lot of good news there that makes me more optimistic after reading the reports. I will try to get to it over the Thanksgiving Holiday, if not sooner. But for a quick overview: the Canroys and the high dividend closed end funds that have just been hammered by hedge fund redemptions and the changing currency situation, continue to have decent earnings and cash flows. None of my high dividend funds has had to cut its dividend yet. That time may come, but there is so much fear built into the prices now, that I am convinced they will weather the storm nicely.

As the high dividend funds / Canroys dip in price, but continue to yield high monthly income, I just reinvest it into the stocks to average down my cost. This way, when the eventual / inevitable rebound comes, my performance versus cost basis will be that much more fantastic. I will have a lower cost but also a lot more shares. And, if worse comes to worse, and they rebound no time soon because the economy goes nowhere, I may have those dividends to help pay my monthly expenses in the event of unemployment! Hope that last one doesn't come true, but we can never know the future....

I continue to think this economic and market situation is most like the mid 1970s. Then as now, we had an unpopular President (Nixon) forced out of office after an unpopular war (Vietnam), which put the country in a generally bad mood. Then as now, we had a massive oil shock that crunched the economy after many years of above average times, making the change in mood that much more dramatic. Then as now, there was a fundamental shift in the manufacturing / auto sector and the creation of new country markets that put pressure on global materials supplies (Japan, Germany, S. Korea, etc). It took us 8 years, till 1982 to recover from the 73/74 crisis. The best investment place to be during that period was in materials and energy stocks, which can withstand and even thrive during a period of weak economic performance, deficit spending and global inflation.

I am copying yesterday's edition of the Prudent Speculator that I receive. First, John Buckingham who runs the newsletter and fund is a common sense kind of guy who keeps his cool. Second, he references quotations from Steve Leuthold, who is a local (Mpls) market forecaster with a very good long term track record. So that is worth reading on its own. Good investing!!


The Prudent Speculator - Wednesday Evening Hotline: November 19, 2008

*** Executive Summary 11/19/08 ***
Near-Term Woes - Retesting the Lows
Long-Term Opportunities - What Does History Say?
Sales - Closed Out ASYT, PLAB & THC
Partial Sale - Sold 50% of ASEI at $71.20 for Certain Accounts
Hotline Special - Buy DAR up to $5.46

Another horrendous day in the equity markets, with the 'modest' 5% decline in the Dow Jones Industrial Average masking the damage done to the overall market as evidenced by a 7.9% plunge in the Russell 2000 small-cap index and the 7.4% drubbing suffered by the S&P MidCap 400. The advance/decline line was ugly as well with preliminary readings showing only 192 winners on the New York Stock Exchange compared to 3,001 losers. The numbers were not quite as bad on the Nasdaq, but a 326/2,524 ratio was dismal as well.

While the catalysts for the giant selloff included renewed concerns about the viability of Citigroup (C - $6.40) and the U.S. auto industry as well as the Commerce Department's report that housing starts fell 4.5% on a sequential basis to a seasonally adjusted 791,000 annual level that is now 38% below the reading a year ago, the Federal Reserve received a lot of the blame as the minutes of the Federal Open Market Committee (FOMC) meeting on October 28-29 were released this morning.

It shouldn't have been a big surprise that the FOMC "generally expected the economy to contract moderately in the second half of 2008 and the first half of 2009, and agreed that the downside risks to growth have increased." This is consistent with the view of many economists, though the participants did lower their collective forecast for growth in 2009 to between negative 0.2% and positive 1.1%. Of course, we would argue that the massive decline seen in equities over the past year might suggest a far worse economic environment than what the FOMC is projecting. Clearly, unemployment will continue to rise into the new year, and the FOMC now predicts that the jobless rate will average 7.1% to 7.5% in 2009, but, again, we believe that the stock markets have priced in a substantial higher number.

Despite our continued optimism for the long-term, we realize that with fear running rampant these days and it unlikely that economic or corporate news will be uplifting in the near term, we have to brace ourselves for more volatility and the likelihood for additional weakness in the short run. Having said that, the technical indicators we look at are about as oversold as they have ever been, suggesting that we are overdue for a significant bounce. For example, the S&P 500 is now 35.5% below its 200-day moving average while the Russell 2000 is 39.0% below its 200-day moving average. Those figures stood at 34.1% and 35.4%, respectively, when stocks began a six-day rally on October 27 which took the S&P 500 up more than 18% from 849 to 1006. During that same time-span, the Russell 2000 rebounded from 448 to 546, or more than 21%. In addition, the Volatility Index (VIX) hit 74 today, not far from the record close of 80 seen on October 27.

We always operate with a long-term, three-to-five year investment time horizon and we continue to think that this period of time will be looked back upon in subsequent years as one of the best buying opportunities in stock market history. As 71-year-old money manager Steve Leuthold said in his latest investor letter, dated October 28:

"If the current U.S. recession (which got underway about a year ago) is about 20 months in duration (our estimate), it would be the longest recession since WWII (average being 11 months). As a leading economic indicator, the stock market would begin to rebound in November 2008, per our historical economic time clock.

"Today's stock market, per our valuation benchmarks (P/E ratios, Price to Sales ratio, Price to Cash Flow ratio, et. al.), is quite undervalued, in the low 15% of our 60 year valuation history. From current valuation levels, the stock market has returned an average of 40% over the subsequent two years and 66% over the subsequent three years, historically.

Obviously, there can never be any guarantee that history will repeat, and we realize that many folks think that this time is different, but we've survived 1987, 1990, 1998 and 2002 by continuing to adhere to the Al Frank strategy of buying and holding broadly diversified portfolio of undervalued stocks. And the market as a whole has persevered through numerous crises with equities seeing long-term returns on the order of 10% to 12%, dating back to the 1920s.

Of course, despite our long-term optimism, we do realize that the companies we own must make it through the near term in order to participate in the eventual recovery. Though we know from experience that the biggest losers going into a bear market are often the biggest winners coming out, we have become more critical of some of the names we hold, opting to sell these stocks a bit quicker than we might have in a more 'normal' market and economic environment. With so many other undervalued stocks available for purchase, we prefer to slowly redeploy these proceeds into other bargains that might offer a little better reward/risk profile.

For example, yesterday we decided to part ways with Asyst Technologies (ASYT - $0.24) and Photronics (PLAB - $0.47), two struggling semiconductor capital equipment companies. With the odds of bankruptcy having risen dramatically, we sold ASYT at $0.23 and PLAB for $0.54. Both companies are presently spilling red ink and with conditions in the tech sector having deteriorated in recent weeks, we are worried that high debt levels may be very problematic.

With the prognosis for hospital owner Tenet Healthcare (THC - $1.46) looking increasingly dire, we decided to finally lay our position to rest this week. In its most recently reported quarter, the company reported that it ailments were becoming more malignant. Bad debt from patients is hovering at 8% of sales, and services are steadily becoming less profitable as a higher percentage of them are to Medicare, Medicade or uninsured patients. Because Tenet depends on more commercially insured patients (admissions of which fell more than 3%), layoffs and the economic downturn have pressured occupancy down to one of the lowest in the industry. With negative tangible book value and debt of $10 per share, we decided to let our THC shares go yesterday at $1.72.

Given the low share prices for the three sales, the value of the holdings at this stage of the game were not enough to move the proverbial needle in terms of performance going forward. Such was not the case for our final sale as Mark Mowrey explains…

In an environment such as this, it's vastly more difficult to justify holding sizable positions in winning stocks with rich valuations, especially when one considers the multitude of inexpensive alternatives into which one can funnel the gains. 'Course it's also tough to move money out of a stock that's been bucking the general trend downward. A smart value investor will put prudence above cupidity, nonetheless, as we did with our holdings of American Science & Engineering (ASEI - $68.04), half of our stake in which we sold yesterday for no less than $71.20 per share for those portfolios where the position was more than 1.3 times the 'normal' size. For Mowrey Portfolio Compiler and Buckingham Portfolio we received $71.25 for the shares sold, while Al received a penny more for TPS Portfolio.

The generally lumpy revenue series took a turn up for American Science in the latest quarter, as the traveler, parcel and cargo inspection systems seller gained further traction in sales of its z-backscatter systems, which produce photo-realistic images of items baddies are carrying or shipping but should not be. Service revenues were higher, too, on account of a higher total number of systems in operation. Margins were on the rise as well.

Meantime, the sales pipeline has continued to grow - backlog is at a record high - as the company targets new markets for products like the z-backscatter vans, intended for use in force protection, counter-drug and anti-terrorism applications. And with intentions here and abroad to further border protection efforts, the long-term outlook is pretty grand.

And, yet, given current market valuation metrics, this stock seems already to have priced in a good portion of that eventual growth, trading at 36 times trailing earnings and more than three times revenue. A price-to-book value measure of 3.6 times is similarly rich, most comparisons considered.

Tempting as it was to hold fast to the shares and hope for greater gains on the whole position, we found it better to sell a chunk of our holdings in ASEI to reduce some of the risk that the rosy picture will fade. The remaining shares we'll hold for a revised-higher target FG price of $78 as the balance sheet is pristine with over $10 per share in cash, net of debt, and fiscal 2009 (ends 3/09) earnings are expected to jump to more than $3.00 per share from the current trailing-12-month tally of $1.87.

Eric Hare pens this evening's Hotline Special on Darling International (DAR - $3.60)…
Darling currently operates in two segments and has been at it since its founding in 1882. Its first segment is the rendering services business, where Darling collects and processes animal by-products, converting them into useable oils and proteins that are needed in the agricultural leather and oleo-chemical industries. Darling collects these by-products from grocery stores, butcher shops and meat/poultry processors. The finished products that Darling delivers via animal parts are pretty impressive. Using meat and bone they can make anything from pet food to fertilizer, using grease they can deliver animal feed and bio-fuels and using tallow Darling can assist in the making of numerous consumer goods.

The second segment, restaurant services, involves the collection of used cooking oils from restaurants and recycling them into high-energy animal feed ingredients and industrial oils. The need for this service is high, as it allows for restaurants to be more productive as it helps streamline the kitchen cleaning process.

A large portion of the by-products from rendering are high growth markets. Demand for new bio-fuels continues to grow and with the new administration starting in January, we’d expect it to at least stay the same. Furthermore, Darling does wonders for the environment. The recycling of fat and protein through the rendering process significantly lowers the amount of green house gas that would have been emitted.

Darling operates all over the world, with the United States providing the majority of its revenue. As a global provider with a proven aptitude in acquiring and synergizing other companies, Darling has an ability to scale the business and offer better prices to customers than any of its regional competitors. The revenue breakout is about 73% rendering and 27% restaurant services.

Operating margins favor the rendering segment as the most recent quarter saw a figure of 19.7% compared with 15.3% for the restaurant services. In addition, margins are improving as the prices at which the by-products can be sold have outpaced the increased manufacturing costs. In the most recent quarter, Darling earned $0.28 per share which compares favorably with the year prior where it earned $0.15. Revenue over the same period jumped to $236 million from $171 million.

A knock on Darling is that its business is capital intensive. The company has to constantly maintain/replace its large fleet of vehicles and heavy equipment for rendering and processing plants. That said, Darling is financially sound, sporting strong free cash flow, a good interest coverage ratio and a net cash position. Management has done a tremendous job of using the strong cash flow to pay down debt and accumulate cash as just last September Darling was showing a long-term debt number that was ten times its cash position.

The valuation for Darling is enticing as it trades for 4.5 times trailing-12-month earnings and for 35% of sales. We recognize that earnings will decline in 2009, but we think that that the nearly 80% decline in the share price since the end of July has been overdone. For those who share our long-term, three-to-five year investment time horizon, we are buyers of DAR up to $5.46 based on an LG/FG pair of $10/$11.

After the Bottom, Then What?

Some day soon, maybe today, maybe in a month, the stock market will find its bottom. Some technicians are predicting 7500, which is the same as the market lows in July 2002 and March 2003. Those form a natural line of resistance for the DJI. Others, like Art Cashin, the CNBC old-timer floor trader, thinks it might be 7000. It is very unlikely the market would crash down to 5000 or 4000. That would require the economic depression scenario, since it will require much lower aggregate corporate earnings to drive stock prices that low. Most think a depression is possible only if the global bankers do not respond with aggressive money creation. So far, the central bankers have responded.

What will be the investment class that does best coming out of the market slump? If you think that all the liquification to unfreeze the financial markets comes with the price of much higher inflation, as I do, then the best place to be will be asset classes that benefit from inflation: hard assets / commodities.

Have you noticed how the global deflationary environment rewards currencies that are doing the most to reinflate their economies, like Japan and the USA? The dollar has soared the past two months from $1.60USD per 1 Euro, to $1.20USD to 1 Euro, a 25% move. The turnaround in Japan is even more dramatic. The yen is now trading at 92Y per $1USD while it was at 120Y per $1USD just a few months ago. The Euro has weakened against the Dollar and the Dollar against the Yen. The Euro has weakend by 40% to the Yen in just a few months. Amazing! And disruptive! How can Japanese export goods compete in Europe after such a currency move? The answer is, they can't. This is why the Japanese Nikkei stock index dropped to a 26 year low today.

This is all about the unwinding of the "Yen Carry Trade" where global investors borrowed the very cheap yen, with interest rates in Japan at only 0.5%, and loaned the same money in other countries at much higher rates, or used the funds to finance commodities futures transactions, which helped drive up commodity prices. With the trade now in full-speed reverse, all that borrowed money is flowing back to the Yen as traders and hedge funds sell their positions and repay their Yen borrowings. As they do so, they convert some / most of their Yen back to US dollars, which strengthens the dollar. Because they are preparing for fund redemptions, they put the funds in very short term, super safe US Treasury bills. This causes competition for Treasury bills causing the interest rates on those instruments to drop to ridiculous low levels of less than 0.25%.

Even the Canadian dollar has gotten into the game, and has gone from parity at $1C per $1USD to $0.78C to $1USD in just a couple months.

On this last point, it has made the performance of the Canroys and other Canadian stocks more dismal when converted to $USD. My Canroy stocks, like Pennwest, Pengrowth, Provident, Canadian National Resources and Daylight Energy, are all down 50% or more the past two months. So is DHG, the closed end high dividend fund that is heavily invested in Canroys. About 1/3 of this decline, though, is the exchange rate. The other 2/3 of the decline can be attributed to the decline in the price of oil, which itself is because of the unwinding of hedge and mutual fund positions. That is a temporary phenomena, so long as I don't have to sell. Since mine are (now) completely unlevered retirement funds, I can hang on till the environment changes. Most of the Emerging Market stocks (Brazil, Mexico, Russia, etc) share with Canada their reliance on commodities for their economy and currency strength. So, emerging markets will also benefit from a global change in sentiment.

What will cause this change? Reflation. Once the markets, and then the economy, bottom, and economic growth reappears here in the USA, but even more dramatically in the emerging markets, global demand will once again increase for all things commodity: energy, grain, metals, chemicals and gold. I do not believe that the global banking system is nimble enough to take all the liquidity back out of the market that has been put in to save the financial system, as fast as will be necessary to avoid inflation. I think inflation, maybe relatively high inflation of over 5%, is a certainty within 24 months. The pain to avoid inflation will politically be just too great, as it will require buying back the financial instruments issued to flood the economy with money. When central banks buy back financial instruments, they raise interest rates in the process and make capital more scarce. It will be hard to take actions that will hurt the economy almost as soon as it starts to get repaired.

So, if you can stomach the volatility, and if you are still invested today, then I guess you have proven you can, hang on to your energy and commodity stocks. If possible, buy more, or at least reinvest dividends to capture more stock at the current low prices. The next couple years will not be much fund. But eventually the sun will shine. And if the 1970s are any precedent, it will shine most brightly on asset classes that benefit from too many dollars chasing too few goods.

Bill Gross, the oft quoted chairman of PIMCO Advisors and global bond guru, agrees with this perspective. Today on CNBC he made took a similar position (I was just happy to be aligned with his perspective, certainly not the other way around). I have posted his appearance for your viewing pleasure (see right hand bar).

www.cnbc.com/id/15840232?video=906626482